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Passive Lineup Dominates Growth at Vanguard

Alec Lucas, Ph.D.
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Vanguard has continued to see massive inflows into its funds, but most of the growth has been concentrated in the firm's passively managed lineup. Joining me to provide a midyear recap of Vanguard is Alec Lucas. He is a senior analyst in Morningstar's manager research group.

Alec, thank you so much for being here.

Alec Lucas: Thanks for having me.

Benz: Alec, it is hard to not see these massive inflows going into Vanguard's lineup, but most of the flows have been concentrated in the index funds and the ETFs. Investors have in fact been selling the actively managed products.

Lucas: They have had good flows into their actively managed bond funds, but equity funds, U.S. equity funds in particular, have been in outflows pretty consistently since 2008. 

Part of the background of the dominance in flows story for Vanguard is their leadership in passive investing. They have seen tremendous amount of inflows, that's continuing, $82 billion thus far through May of this year. Second-ranked is iShares. So, that gives you a sense of the fact that passive is really driving their dominance in flows in recent years, sort of post-financial crisis. Prior to the financial crisis, they were roughly even in actively and passively managed assets and there's been a pretty significant divergence since the financial crisis.

Benz: The fact that Vanguard has been continuing to see inflows into its taxable bond lineup, that mirrors what we are seeing elsewhere in the fund universe, where it seems that within the bond space at least, investors haven't completely lost faith in active management.

Lucas: There's probably a number of reasons for that. Retirees, the baby boomers retiring and becoming a little bit more conservative. Obviously, we've had a very good run in the equity market. And so, perhaps investors wanting to lock in some of those gains.

Benz: With some of these asset inflows have come some headaches including some gripes from customers about customer service, where they have called Vanguard and maybe have had long hold times or other problems. Let's talk about that and I guess, as a sort of caveat before we get started, it's really difficult for us to know what customers at-large experience in terms of the interactions they have with any firm, not just Vanguard.

Lucas: There are important points to make when we talk about customer service and challenges Vanguard has had. Other firms haven't had the inflows they've had. I think that pretty much any firm would struggle with the degree of inflows that they've had. That said, by their own admission, 2016 was a rough year for them. They had a huge amount of inflows, a huge amount of paper inflows, and they also had some challenges in being appropriately staffed.

They've really taken significant steps to address that. They have started a client experience group. They've started a lab testing approach. They have tried to simplify forms like transfer of asset forms, reduced the complexity, reduced the jargon, reduced the length of those forms. 

The goal is to launch 12 client-testing labs by the end of 2018 and help a client who, say, is a millennial starting out and just begins investing with Vanguard to somebody who is in retirement and is beginning to spend the money they have spent all their life saving. They want from beginning to end, a client's experience to be pretty smooth. 

They have got this lab testing approach to help refine that. I think that should help improve some of the problems they have had. They continue to have problems with account balances and technical glitches, but they are certainly aware of it and investing in it. I think it's important to recognize that that comes in a context of significant flows.

Benz: Major leadership change going on at the outset of 2018 as well with Tim Buckley taking the helm. Let's talk about that.

Lucas: He is a Vanguard veteran. He took over in January of 2018. He is their fourth CEO. He started at Vanguard in 1991, and his first three years on the job, he was the assistant to founder Jack Bogle. He is somebody who is very close to the company's origins. He did his MBA at Harvard and then came back to the company in 1996 and has been in leadership since 2001. Most recently, he was chief investment officer. He is very well-positioned to lead the company in terms of his experience and broad knowledge about the business.

Benz: I also want to cover a couple of new fund launches. One is just announced today with some ESG or environment, social, and governance products, index-based ETFs coming to market. Let's start with those, but I also want to talk about Total World Bond Market that launched earlier this year.

Lucas: In May, there was the Total World Bond Market ETF that they launched. More recently, just today, so fresh news, U.S. ESG ETF and an International ESG ETF. This follows upon the February 2018 launch of six actively managed multifactor--well, one is a multifactor fund and then the other are single-factor funds. We see Vanguard trying to be relevant in areas where it thinks it can serve investors well and do it at a low cost.

Benz: Certainly, there are some data to indicate that the millennial population in particular likes ESG strategies in general.

Lucas: For sure.

Benz: Let's talk about performance at the firm's funds, starting with some funds that so far in 2018 have performed particularly well.

Lucas: Big-time leadership from Vanguard International Growth. This is a fund that got nominated for Manager of the Year in 2017.

Benz: One that I own as well.

Lucas: It's doing really well this year again. It's got a couple of subadvisors, Baillie Gifford and Schroder. Those two subadvisors have done very well of late. Some other standouts for Vanguard are index funds. It shows why they are getting flows into that area. For example, the Vanguard Extended Market Index Fund invests in U.S. stocks outside the S&P 500 …

Benz: So, small and mid-cap stocks.

Lucas: Yes. Small and mid-cap stocks. Those are funds that are really leading the way for Vanguard this year.

Benz: In terms of disappointments so far in 2018, understanding that we are just talking about a six-month period, so, not judging based on such a short period.

Lucas: Among medalists, Silver-rated Vanguard Selected Value is not doing as well this year, it's a mid-cap value fund and it's not been a strong environment for value. That's lagging. Vanguard Primecap Core, it's in the large growth category even though it's got a core mandate, it leans toward growth. But both, the Selected Value and the Vanguard Primecap, have great records over the past decade, so I wouldn't jump the ship.

Benz: I do own Primecap Core as well. Let's talk about what's next for Vanguard. You talked about trying to resolve some of the customer service experience issues. In terms of other things that you think are key priorities or things that are on the horizon for the firm--what sorts of things would you point to?

Lucas: They have been trying to expand overseas for quite some time, but regulatory changes, fee pressures, changes to distribution, I think they are well-positioned to make some real headway there. They have got about $400 billion in assets among non-U.S. investors. Really, what they have been doing is trying to gain distribution footholds in countries by leading with ETFs and index funds. 

Vanguard is though not just committed to indexing but to low-cost investing. Active management is a part of that. They are launching some actively managed funds in Canada, for example, they are in the midst of doing that. One of them is a clone of Vanguard Windsor. I think the real challenge for Vanguard as they expand their business overseas is to not ignore the active management part of their business and to really strive to find home-grown asset managers in the countries they are trying to get a foothold in, the Primecaps of Canada, if you will, as well as strong subadvisors. They have got really good relationship with Wellington Management as well as Primecap. Those are two standouts for them. Baillie Gifford is another.

The real challenge, and of course, Baillie Gifford is not in the U.S, but the real challenge as they expand in a place like Canada and elsewhere is to find strong active manages and that's a place that they have room to grow.

Benz: Alec, thank you so much for being here to provide a recap of what's going on at Vanguard. I know there are a lot of eyes on the firm. I appreciate you providing an overview.

Lucas: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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